I was wrong with the header bidding angle, but have been right about the company (so far).

Header bidding is an advertising technology designed to source the best pricing for ad space on webpages. This isn’t the ad space that Sito Mobile operates in. Sito operates in the mobile app ad space. They have an interesting offering. Here is how Sito described what they do at the Cowen Conference last year (I’ve paraphrased a little for brevity).

What you see here is a day in the life of a mobile user. Its important to note that when we interact with our phone and click on an app, we are raising our hand and saying serve me an ad. Our platform sees every one of those bid requests. If you look at this user (see timeline above), this person wakes up in the morning and clicks on their weather app. Every time that they click on an app we gather information. We gather a minimum of 3 data points and depending on the app and agreements, up to 30 datapoints. At minimum we gather the geo-location, time stamp, and the device ID. All the data is anonymized. That’s the foundation of how we create something called player cards.

The next time we see this device ID at a geo-location its 7:15AM. It’s an elementary school. The next time we see the device ID its at a geo-location that is a Planet Fitness. So you now see a pattern. Next we see it at a grocery store. Last we see it at 10:04AM is at a location we’ve seen the device 382 times in the last 30 days, so we can infer that this is likely the home address. Then we can get additional data from the Wifi about number of devices and carrier for that home address. We can then layer on third party data from Axiom and DLX and the like to layer on things like household income, demographics around that area, and we start to build a profile. We never know 100% but in this case we have a high degree of probability that this is a Mom, age 35-44, Caucasian, lives in zip code with average household income of $220,000, college educated, likely own their own home, average length of residence is 7 years, married and has average of 2 children ages 2-9.

That now goes into an audience that we create. We then layer in her interests and that resulting player card can then be used to target advertisers who want to speak to this consumer.

Once a user has been targeted with the ad, Sito can follow-up on the path that the user follows. Via it’s Verified Walk-in product Sito can report back whether the user subsequently entered the premises of the ad vendor, thus verifying whether the targeted ad was a success.

While some would legitimately remark that it’s scary how much can be known about you by carrying your smart phone around, the other way to look at it is that it is that the platform should result in more relevant ads being presented to users. The mobile location history that Sito collects allows it to profile the user, understand their interests and routines, and then target an ad that is appropriate and maybe even useful. And because of the real-time location data, the ad is also relevant to their current location. The verified walk-in allows Sito to report back to the advertiser with accurate metrics about the campaigns success. The value proposition makes sense to me.

The stock price suffered into the new year for two reasons. First, the company badly missed expectations in the fourth quarter. The fourth quarter should be the best one for advertising. Yet media placement revenue was down from $10.4 million in the third quarter to only $8.3 million in the fourth quarter.

This was compounded by news of malfeasance by the CEO and CFO. Apparently they were making unapproved purchases with company credit cards, debit and withdrawals from payroll funds. In total $330 thousand dollars that were misappropriated. In February these executives resigned.

So there was concern that the companies growth trajectory was failing and concern about the void at the executive level. The stock plummeted down into the $2’s.

I got interested after the company released its first quarter results. In fact I think (I can’t remember for sure) I got the idea after reviewing a list of percent gainers the day that they reported.

The first quarter results were better than the fourth quarter. Revenue was down from the fourth quarter (not unexpected given that January is typically a dead month for advertising) but up 34% year over year. More impressive, the company said that it had its best month ever in April, generating over $4 million in revenue, and they guided to a range of $10 million to $13 million in revenue for the second quarter. This would be far above the $8.3 million of media placement revenue for the prior year.

So I like the offering and I like the recent growth trajectory. When I bought the stock at $3 the market capitalization was a little over $60 million, which meant that it was trading at less than 2x forward revenue, quite cheap if the company has indeed regained its growth mojo. Even now, at $4, its still only 2x revenue, which is not an expensive price tag if 30% revenue growth is really in the cards.

So it’s a simple story. Growth business, product/service that makes sense, they even have a wealth of data that they have archived over the past couple of years that they are beginning to monetize as data as a service and that will provide an additional revenue stream. Simple.

Except its not. The complicating factor comes from two activist groups that are looking to replace the board, replace the new CEO and CFO and I think put the company up for sale.

The two groups are the Baksa Group and TAR Holdings. The latter company is owned by Karen Singer, wife of Gary Singer, who had this interesting article written about them a few years ago. I didn’t know anything about either of these groups before investing in Sito. Singer and TAR own over 10% of Sito while the Baksa Group own a little less than 7%.

The groups say that they are not affiliated, though they seem to support each others claims and want essentially the same thing. What they want is the removal of the executive team (the CEO and and CFO) and replacement of 4 of the 5 directors. In this filing (one of many) the Baksa Group describes their position and what they are looking to change.

There are lots of complicating and curious angles here. Just to throw out a bunch of facts: Stephen Baksa was a director of Sito from 2011 to 2014. The Baksa group appears to be supported on the board by one of the Sito Directors Brent Rosenthal (the only director they don’t want to replace). One of the Baksa nominees purportedly has a “working relationship” with the Singers. Some of the Baksa nominees sit on the board or are affiliated with a company called Evolving Systems. Karen Singer owns 21% of Evolving Systems. A couple of Singer’s relatives work with Evolving Systems. And it seems like all of this activism started shortly after a March meeting between Sito management and Thomas Thekkethala, who is the CEO of Evolving Systems and was to become one of Baksa’s board nominees, where they met to “discuss a potential licensing arrangement that would allow the Company to market its products to Evolving Systems’ customers outside the United States”. It was 4 days after that meeting, on April 4th, that Sito adopted a poison pill and the activist ball got rolling.

I don’t really know what to make of the activist angle. Maybe this is all a way for Evolving Systems to take over Sito, maybe there is something else going on. I really have no idea. I’ve read through all the filings and I honestly couldn’t pick out any tidbits that gave me certainty about the outcome. Where we stand now is that the Baksa group has delivered a proxy signed by 58% of common shareholders supporting their proposals to remove the current executive and directors and replace them with the Baksa slate. Sito has responded that they are having a third party do a count and validate the results and will report back next week.

While I am really not sure about the outcome, it seems to me that its at least possible that this ends in some sort of acquisition of the company. Management has their backs against the wall with the recent proxy. The easiest way out of the corner is a takeover, either by Evolving Systems or some other white knight. And if it doesn’t happen, there are always the fundamentals to fall back on, which is the real reason I bought the stock.

I wasn’t planning on writing anything about Identiv’s first quarter. There was nothing that stood out about the results. The company reported so-so year over year growth (7%) that was hindered a little by slower growth in their Physical Access segment (5%) which is seasonally weak in the first quarter. The Credentials segment grew at 11% and the Identity segment grew at over 20%.

The company reiterated guidance, which was set at $64-$68 million in revenue for the full year 2017 and EBITDA of $4-$7 million.

Nothing exciting. Until the company decided to offer stock.

The news came out on Thursday. It was priced by Friday morning at $4.85 and oversubscribed. The pricing was favorable when compared to the close Thursday night (there was essentially no discount) but when you consider the stock has had maybe 3 or 4 up days in the last month, not so much.

So why did they do the offering?

The simplest explanation is that the stock price has moved significantly in the past few months, the company has only a small cash position on the balance sheet ($7 million) and the board thought it was prudent to raise funds (it ended up being about $12 million). This would be the Occam’s Razor explanation.

While it’s probably as simple as that, there are some circumstances that make me wonder if other reasons were at play. First, why would they do a share offering so close to the annual shareholders meeting? It seems odd to raise the ire of shareholders right before they get their chance to speak to management unless the timing was precipitated by some specific need of cash.

And speaking of the word precipitate, there was an awkward exchange on the first quarter conference call between Stephen Humphreys (Identiv’s CEO) and an analyst. The analyst asked about the recent shelf that Identiv filed. Humphreys provided the usual run-around, the marketplace is exciting, looking for opportunities, making sure they have access to funds if something comes up. But he also said there was “nothing precipitous”. That seems to me like an odd phrase to use if you are one week away from issuing equity. He didn’t have to give that color. So why did he, or what changed in the following 7 days?

Also on the call was an odd disclosure by Humphreys about potential opportunities. In his prepared remarks Humphreys explained the three tiers of growth for the company. First is the base business growth. Second is finding upside in their existing platform of products, new target markets or solution packages. And the third is “disruptive growth”. Humphreys spent some time on this, explaining how the company positions itself for a “black swan” event and “aspire for moon shots” with its “disruptive and transformational solutions”. There was nothing specific in these remarks, which made me think it was odd to mention it at all. What was the point? Put yourself in the position of CEO. What would cause you to decide to write prepared remarks discussing moonshots and black swans? Would you really decide to do that on a purely hypothetical basis?

Finally there is the move in the stock price. I was pretty surprised to see Identiv rocket up over a dollar after announcing the public offering. I’ve seen an offering lead to a positive move in the price of shares, but its usually happens to a company where investors are concerned about solvency and the offering puts those concerns to rest.

So I don’t know. Maybe the move was just a reaction from a very oversold state. Or maybe it had to do with the underwriter. Whatever it was, there was nothing I could find in the prospectus or its follow disclosures to justify the reaction. They were very standard documents. It will be curious to see what transpires over the next few weeks and to see what they use the cash for.

With the acquisition of Apicore, Medicure took on much more debt than they previously had. In order to acquire Apicore they added about $60 million of debt. The debt isn’t cheap, at 9.5% plus 400,000 warrants that they issued for shares at $6.50 (they say in the MD&A that the effective interest rate is 12%). With a market capitalization of $100 million, the additional debt is not inconsequential.

The debt isn’t crippling, but it makes it crucial that Apicore performs in an accretive manner. But from the disclosures provided by Medicure, it’s not clear to me just how accretive Apicore is.

The Apicore deal closed December 1st, 2016, and the one month numbers were excellent, sales of $7.8 million and gross margins of $4.5 million (after adjusting for inventory at the time of the acquisition). But on the conference call the company said that December is by far the strongest month for Apicore and that we should not expect that level of results over the full year. In the financial statement Medicure disclosed that had Apicore been part of Medicure for the full year, net income would have actually been lower, which is a bit worrisome:

On the other hand, in the quarterly presentation Medicure gave color around additional EBITDA from Apicore had they been consolidated for the full year 2016. It is significant (around $6 million). But I don’t know how to reconcile that with lower the net income?

Its not so much that I think that Apicore is going to be dilutive to earnings. I doubt that. It’s just that the company hasn’t made it clear what to expect so it’s difficult to forecast going forward.

The other development that gives me pause is that there has been a move to 2-6hr infusions of Aggrastat. Basically physicians are using Aggrastat for shorter durations. This helps them limit side effects and they are seeing acceptable efficacy. The company described this as a positive development because A. Aggrastat is the only glycoprotein inhibitor (GPI) that has shown efficacy at the shorter infusion time, and B. the reduced side effect profile will lead to usage by physicians previously wary of using GPIs. I quote/paraphrase the comments around this from the call below:

Only about 15-20% of physicians use a GPI. This used to be 75%. The reason for decline is bleeding risk. Because Aggrastat doesn’t have a minimum infusion time, it is better positioned for physicians that don’t use or minimize use of GPIs

While it may end up being positive, I can’t help but think that in the short run this is a headwind for Aggrastat demand. Physicians are going to be using less Aggrastat, that seems like the bottom line here until these other factors catch up.

The final thing that I didn’t love about the disclosures is I found some mistakes in it. For example, on page 25 of their MD&A the total debt does not add up from the constituent pieces. Similarly, on page 24 their operating income isn’t right in their EBITDA reconciliation (though the actual EBITDA end result is fine).

Nevertheless there are positives. With the acquisition of Apicore, Medicure has a number of generics on the horizon that will generate growth.

In March Medicure announced FDA approval for tetrabenazene, which is a generic form of a drug used for Huntington’s disease called Xenazine. Xenazine had over $300 million in sales in 2015, so if the generic can take a decent percentage of that it could be material. They also filed an abbreviated new drug application (ANDA) for a generic in December and have two others in the development stage. In total there are 15 ANDA’s in the pipeline.

So there is quite a bit of potential for growth. But it could still be a number of quarters off. Meanwhile the stock has an enterprise value of over $150 million and trailing EBITDA of $15 million, so it’s not particularly cheap. I do like the growth pipeline though. I’m just not sure at this point, so I took some off.

Radisys stock has been pretty flat since it announced its first quarter results, and while I can understand that lack of interest, I nevertheless was pleased with what I heard on the call.

The first quarter was on the low end of guidance. Revenue came in at $37.6 million, while the company had anticipated a range of $37-$41 million. Guidance for the second quarter was $41-$47 million, which is pretty close to my expectation, though maybe the top end is a couple million higher.

The stock didn’t move on any of this and it shouldn’t have. There is nothing surprising. The Radisys story continues to be a wait and see one. We wait for announcements of new DCEngine, FlowEngine, and MediaEngine orders and we’ll see if they materialize.

There was lots of qualitative progress on this front but not much quantitative in the way of meaningful orders yet.

Here are the highlights:

Verizon announced their Exponent platform in February. The platform allows carriers to deploy off-the-shelf(ish) next-gen solutions using technology Verizon has developed. Brian Bronson (CEO) said that DCEngine and FlowEngine are designed into the Exponent solutions and that they have seen incremental customer relations develop. While this is very new and the relationships are mostly still in the early stages, Bronson did say that “a couple of engagements are fairly close”.

A second partnership was announced with Nokia. This one revolves around MediaEngine and to me seems very significant. Nokia will be marketing MediaEngine as their single MRF solution. The Alcatel-Lucent MRF will be mothballed in favor of the Radisys product. The partnership is expected to open access to new CSP customers. They expect that given Nokia’s customer base, MediaEngine will be the MRF in 3 of the 4 CSPs in North America, and that there are opportunities in Asia/India as well (beyond Reliance). In the past there were a number of MediaEngine deals where MediaEngine saw a half share win (with the Alcatel-Lucent MRF picking up the other half) but will now have the full deal go to MediaEngine.

They are close to closing 3 new carrier wins with DCEngine. First, they are pretty close to signing a master agreement with a US Tier 1 CSP. They said this wasn’t Verizon (already the primary DCEngine customer) so I think it has to be AT&T (??). They were confident enough to say that they expect purchase orders this quarter from this operator.

Second, Reliance Jio is trialing DCEngine for a single use case and they expect orders with respect to this use case in the second half. Third, a South East Asian CSP has received proof of concept DCEngine units to in the first quarter for a use case that has a revenue potential of around $20 million.

They formally announced the new FlowEngine, called TDE-2000, in the first quarter. Management provided color around a strong response and the initiation of trials and proof of concepts but nothing specific. They did say that Verizon is using the older version of FlowEngine for a new packet-inspection use case (they have used it in the past as a edge-router) and that they expect “incremental deployments in the second half” for this use case. Bronson also said that by year end he expects that at least one of the DCEngine wins will incorporate FlowEngine.

With MediaEngine, the big news is the Nokia partnership that I already mentioned, but there also appears to be some progress around transcoding. They are still looking “to disrupt transcoding”. I talked about how MediaEngine provides an alternative to session border controllers (SBC) to perform transcoding operations in this post (there is also a good youtube video on how MediaEngine can save money on transcoding) The punchline is that Radisys can offer a solution that is 3x to 5x cheaper. On the call they disclosed that MediaEngine is already deployed to a small extent performing the transcoding function with a couple of operators, which is new information. They also have a new “in” with operators, as they can leverage the Nokia-ALU relationship. Nokia-ALU is the number two SBC provider in the world. Bronson said there are a couple of operators that have “strong interest” and that they are looking to a 7-figure deal.

So is it good or bad?

You can look at this one of two ways, You can optimistically count up all the engagements, trials, proof of concepts and agreements on the verge of being signed and think that the second half of 2017 and 2018 are going to be a great ramp. Or you can pessimistically point out that nothing has been signed yet, there is still very little incremental revenue beyond Verizon, Reliance Jio and some piecemeal one-offs and that the clock continues to tick.

Both of these perspectives seem perfectly valid. I prefer to take the first, mainly because I believe the upside in the stock is significant if it turns out to be right.

The win is for the design of a new, custom 100G switch fabric NIC to be deployed in datacenter racks. The design presents a number of technical challenges and they are still working through those challenges. So far Silicom has received an initial $25 million purchase order and a follow-on $8 million order from the customer. The PO’s are being written even though the card is still in the beta phase and thus still under development. The PO’s are to insure that Silicom has components on hand and can ramp production quickly to the $30 million plus run rate once a final design is approved.

Interestingly, Shaike Orbach, Silicom’s CEO, said that they were engaged with 10-15 other cloud players for similar designs. He tempered those remarks by saying that the sales cycle was long (can take as much as two years), that some of the engagements would be for smaller wins (but some could be bigger) and that the architecture of all cloud vendors do not line up as well with Silicom’s technology as this vendor did.

At any rate though, there is a large pipeline of potential deals. As an aside, if anyone knows who the existing win is with, please email or direct message me.

SD-WAN

There were also comments around SD-WAN. They have a similar number of SD-WAN prospects that they are talking to (around 10). These include traditional telecom vendors that have SD-WAN solutions, start-ups, and even service providers. Talking directly to service providers is a new development as Silicom has traditionally worked through OEM vendor channels.

There was a bit of color around the potential of the SD-WAN opportunity. Alex Henderson from Needham asked the following question:

If it’s the entire white label box at the edge, I would think that A, that would be a little bit lower margin but B, a lot of revenue associated with that because we’re talking about 1000s of branches and individual deployments here, that seems like a very big ramp when that starts to kick in. Am I thinking about that right? I mean it seems like a very large number?

Orbach’s response was to agree that potential quantities were “very big” and that they had some competitive advantage in that they could provide features not available from others. I’m still quite excited about the SD-WAN opportunity.

FPGA Opportunity

One comment that came up a few times on the call was the growing importance of their FPGA solutions. Orbach said that while the switch fabric win is not an FPGA solution, Silicom’s FPGA capabilities were instrumental in getting the win as the customer expects future generations of the product to require FPGA’s.

At the end of the call Orbach gave more color around the importance of FPGA solutions (my underline):

So first of all I would like to tell you that we think that FPGA technology and solutions around FPGA are going to be extremely, extremely important. We’re investing in that. You understand it may take some time but we believe that it will be extremely important. Just like you have said, I mean one of the reasons I mean there are two I would say trends, not trends, but two events and — well even event is not the right word but two things which are happening together which I believe are important to understand, maybe even three. So one is again the cloud, I mean the cloud, I think that cloud vendors do understand today and that’s by the way why we have been able to success even with that customer that in order for their cloud to be effective, in order to cut down their expenses they need to have several ways or to do offloading within the cloud. Our FPGAs seem to be recognized now almost by everyone as the right technology for the purpose of doing this kind of offloading. I think that although — when I’m saying cloud by the way I mean the whole package, I mean it’s cloud and NFV, SD-WAN virtualization, all that together. So when build systems using these technologies you would need to do offload, the right technology to do offload is FPGA.

Orbach also hinted at collaboration with Intel (and their Altera FPGA designs) and referred to a MOU around FPGA development that he said was important.

I did a little bit more research into FPGA development and this looks like an area that is beginning to hit its stride with more and more use cases. FPGA designs offer more flexibility, less up front cost and are preferable to vendors that either don’t want to commit a large spend to a custom ASIC design or do not have funds to commit to such a closed end design. It sounds like the performance gap with ASICs, which has largely been what has limited their use, has closed considerably over the last few years.

In particular I found one white-paper by Altera/Intel that was particularly insightful. The paper describes 3 evolving use cases for FPGA’s that all seem very closely aligned with Silicom’s strengths. They are:

Datacenters

400G cards

Wireless Remote Radio Units

The paper basically suggests that the requirements of the next-gen designs will fit much better with FPGA solutions than ASIC solutions.

While Orbach and the above paper suggest that big FPGA wins are still some time in the future, it really starts to clarify the runway of opportunities for Silicom for me. I think this could be a multi-year run for the stock as the company seems very well positioned for trends to white-box hardware, offload functionality to secondary NIC cards, and utilize more FPGA based solutions. I didn’t add to my position on the results, but if there was enough of a correction I certainly would.

I’ve fallen behind writing about the earnings reports so far this season. In the next few posts I am going to catch up with a few brief thoughts on a number of the reports that came out over the last week and a half. Starting with…

Radcom

I’m surprised the stock has moved so much after the company reported first quarter results on Thursday. I didn’t think there was a lot of new information provided. Revenues ($8 million) were in-line with expectations, guidance was maintained, the trials are progressing. On this the stock has jumped almost 20%. Go figure.

I guess investors have focused on the progress. The four trials are wrapping up, and within the next 6-9 months they expect so be able to announce wins, though nothing specific was provided. Ravkaie (the CEO) gave positive color around the potential for wins, but that isn’t anything new, he’s been saying that since the trials were announced last summer. They indicated discussions with new carriers that will begin trials in the third and fourth quarter. And some of the tenders that are now coming in are for pure NFV solutions, which is a new development (most of their engagements were for hybrid deployments as carriers transitioned slowly to NFV) and one that should play right into their wheelhouse.

I unfortunately got shaken out of about 25% of my position the day before earnings. Doesn’t it always happen that way. Netscout, a competitor, announced a win with Vodafone that day, and my initial reaction was that maybe Radcom had lost that trial (though no one is sure who Radcom is in trials with, one of the companies that comes up in discussions is Vodafone).

On further reflection, that might be wrong. It was pointed out to me that the Netscout press release refers to passive probes, which are not the same thing as the active probes that Radcom’s MaveriQ solution uses (passive probes are more akin to offline testing and measurement which would be like the sort of thing Exfo does). Second, on the conference call, Ravkaie was specific about calling out Netscout as a competitor and saying that they do not have a comparable NFV ready solution to compete with Radcom. So it seems more doubtful to me now that the Vodafone win is a loss for Radcom then it did at first glance.

Honestly, I think my move was driven as much by position size as the Netscout news. Whenever I have a position that is big I get quick on the trigger with any rumor to the contrary. The fact is that the morning of earnings I had the opportunity to add back at 18, but I didn’t. I was not convinced the results were incrementally better to justify running back in. That proved to be wrong, at least for now. So I will just participate in the move with the shares I have and see whether it is for real.

Portfolio Performance

Top 10 Holdings

Thoughts and Review

In my June update I took space to describe some of the attributes of my edge. At that time I didn’t define it specifically, and so I wanted to extend that discussion here. To repeat the definition that I put forth back then:

An edge is essentially the advantage that allows you to beat the market more than it beats you. For many of these traders understanding their edge; a system, a pattern, a money management technique; has been a major step toward consistent success.

I think I have put up enough years of out-performance to tentatively conclude I have some sort of edge. Its still possible that I don’t; maybe I will blow up yet and these past years will prove to be a statistical aberration. But as times goes on those odds become less likely.

So what is it?

First, I do quite a bit of research. Now maybe I’m not the most exhaustive researcher; I know some folks that will, at minimum, read through the last 5 years of 10-K’s before pulling the trigger, but nevertheless I am on the heavy side of the research spectrum. I think its fair to say that I make decisions on a more informed basis than the average investor.

Second, I’ve come up with a methodology that works, both absolutely and for my personality. I take small positions that let me be wrong without losing a lot of money. I rarely add to those positions if they fall and sometimes cut them if they fall too much even if I have no news to suggest anything has changed. And I add to the positions as they rise and price movement reinforces the thesis.

This works for me because in the real world I’m not very good at making decisions. Just to give a couple examples from every day life, I don’t like having to choose the TV show we watch at night, what food we will have for dinner, or where we are going to go on vacation. I would rather have someone else make the decision and just go with the flow. I am fortunate to have an understanding wife.

I invest in a way that is in tune with this nature. I rarely commit to an idea unless I am deep into it. Even with my biggest positions; Identiv or Combimatrix or Radcom, I don’t feel sold on the ideas. I’m more of a renter. I am not sure if they will pan out and I am ready to run if something goes awry. It’s easier for me to pick a stock then what’s for dinner because I know it’s not for good.

The final element of my edge is the type of stocks I look for. I try to find companies that, while they may only have a small probability of going up, have the chance to go up by multiples if things play out in a certain way.

To put it another way, if I am right 30% of the time and on average my gains are 20% and my losers are 20%, I am going to lose money. But if my gains can be 100% and my losers 20% then I am going to do quite well even if I’m wrong most of the time. So I am wrong a lot, I change my mind a lot, but when I’m right its often for a double, a triple or even more.

What I did last month – Aehr Test Systems

Its actually been 5 weeks because we were on vacation for the last week and so I didn’t get this update out on time. Even with the extra week, I didn’t do too much. In fact I only made three trades. One, Catalyst Biosciences, was a fluke that I discussed in my last update. The stock is back down to where it was and I didn’t actually buy it anywhere but the practice account so who really cares.

The other two were new positions. The one I’m going to mention in this update is Aehr Test Systems. They are a fairly tiny company ($90 million market capitalization) that makes testing equipment. They have a unique design (I don’t believe there is a lot of direct competition) that can test at the wafer level rather than the module level, which eliminates much of the potential for mechanical failure and improves quality controls. They started selling a multi-wafer testing machine called the Fox-XP system back in July and they have started to see orders come in. Their test equipment is sold to some large companies, like Apple and Texas Instruments (Apple and TI accounted for 47% and 32% of revenue in 2016) and they have made references to being in talks to sell product to a Korean firm that seems likely to be Samsung.

The stock doesn’t appear cheap at a glance. Revenues in the last 9 months were only about $12 million so on a trailing sales basis the stock looks wildly overpriced.

What makes it interesting is that we are only starting to see orders for the Fox-XP system. So far these orders have been for prototypes to verify the concept. The units sell for $4 to $5 million, so even a trickle of prototypes are incrementally material to the company. But the orders could scale substantially if the proof of concept testing goes well. The company doesn’t give a lot of guidance, and there isn’t much of an analyst following to prod information out of them, but on the third quarter conference call management said that if successful with their lead customer (probably TI?) they could ship 10 systems a program and that they are currently working on 2 programs. So the lead customer alone could amount to a $40 million to $60 million opportunity per program.

If the Fox-XP takes off, the stock is going to move significantly. Will it? I don’t know. It has a chance though, and that is worth a small position.

The dangers of short-term funding

In October of last year I wrote that I was short Canadian alternative lenders and mortgage insurers in the wake of the Federal government mortgage rule changes. For 5 months these positions did poorly. I began to think my puts would expire worthless and my shorts would be tax loss candidates. But last week the bet was vindicated as I took profits after the alleged fraud at Home Capital.

My thesis was not premised on the discovery of fraud. I thought there was a reasonable chance something would be uncovered as the market unwound but that wasn’t my primary reason for going short. Instead I thought the measures the government put in place in October would finally cool down the housing market and that, given that many of the measures were targeted at alternative lenders and insurers, these companies would suffer the most.

That hasn’t happened, so in that way I was lucky. But what I did get right was how things would unravel once the ball got rolling.

It cannot be overstated how precarious a company is if they lend long, borrow short and have a funding source that is easily called away. If any uncertainty develops about their lending book, the run on funding can be swift and fierce.

The collapse of Home Capital was precipitated by their dependence on high interest deposits to fund part of their loan book. Those deposits were available on demand, so at the first allegation of wrongdoing, many were pulled. Why not? Who wants to take a chance with their money for an extra percent. Adding to this outflow, there is and will continue to be a slow motion run on their GIC funding, many of which will mature over the next year and almost assuredly not be renewed.

This capriciousness is why I don’t have the stomach to hold non-bank financials through any bouts of turmoil (think back to New Residential or Northstar). You just never know when the funding side is going to tighten, and when it does an extremely profitable business model can be flipped to insolvency in a heartbeat. Again, and I know I’m repeating myself, but I don’t think you can over-state how precarious it is to lend-long, borrow short and have funding callable on demand. Everything is great until it isn’t, and then it’s all over.

As for the Canadian housing market, it continues to tick on. It will be interesting to see how the events of the last week interact with the price rise of homes in Southern Ontario and coastal BC. We are all familiar with how the US played out. There the topping out of prices was the catalyst that collapsed the loans and tightened of credit. I wonder if it has to play out that way, or whether causality could be reversed in Canada, as lenders for marginal buyers lose their funding sources in the wake of Home Capital?

We’ll see. We sold our rental property a few weeks ago so I don’t even have that chip in the game anymore. However that wasn’t driven by macro worry; instead we realized that renting is very time consuming and not very profitable (unless you live in the GTA or the coast and your house can appreciate in value by 30% in a year). Our last tenant also turned out to be a convicted criminal which didn’t help my stress level last year.

It will be another interesting week.

Portfolio Composition

Click here for the last five weeks of trades. I had to make two adjustments to the portfolio that show up as trades because of name changes that weren’t automatically updated in the practice portfolio. Accretive Health recently changed their named to R1 RCM and a while ago Limbach changed their symbol to LMB. The Limbach situation was brought to me by a reader. Its been wrong in my update for a while (displaying the old symbol and last traded price of it). This has been corrected now.

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